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Chapter 11: Q3. (page 236)

Why is saving called a leakage? Why is a planned investment called an injection? Why must saving equal planned investment at equilibrium GDP in a private closed economy? Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain.

Short Answer

Expert verified

Saving is called leakage because saving reduces the amount available for consumption expenditure.

Planned investment puts money in the economic system and is therefore called an injection.

Saving and investment should be equal to stabilize the economy.

Unplanned changes are constant at equilibrium GDP.

Step by step solution

01

Step 1. Saving as a leakage

Saving is the money withdrawn from the economy’s total spending. Because of savings, part of income is excluded from the economic system, which reduces the multiplier effect.

Thus, savings reduces the amount available for spending. This is why it is treated as a leakage.

02

Step 2. Planned investment as an injection

The planned investment adds money to the total spending of an economy. It is the cost of capital goods purchased that are used to increase production.It encourages output growth by increasing total spending. Since investment adds money to the economy’s total spending, the planned investments are called injections.

03

Step 3. Equal saving and investment at the equilibrium of a private closed economy

If savings are not equal to investment, the economy will not be stable.

  • Savings>investments: The total spending will fall short of output, demand will be less than supply, there will be downward pressure on prices. The firms will be forced to cut down the production. This will continue till the demand equates to supply. The decline in output will reduce the income. And eventually, savings will decrease due to income fall until it equals investment.
  • Savings<investment: Total spending will exceed the output. Thus, firms need to increase the production rate to maintain the equilibrium. The increased production will increase income and saving until saving equals investment.

Therefore, for maintaining equilibrium in a private closed economy, savings should be equal to investments.

04

Step 4. Constant unplanned changes in inventories at equilibrium GDP

At equilibrium, there are no changes in the unplanned investment. An unexpected increase in investment would mean an excess of total spending beyond the economy’s output level. On the other hand, a sudden decline in investment would reduce the total spending and lead to an overproduction problem. Therefore, the unplanned investment has to remain constant to maintain the equilibrium of a private closed economy.

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Most popular questions from this chapter

Other things equal, what effect will each of the following changes independently have on the equilibrium level of real GDP in a private closed economy?

  1. A decline in the real interest rate.

  2. An overall decrease in the expected rate of return on investment.

  3. A sizable, sustained increase in stock prices.

Assume that the consumption schedule for a private open economy is such that consumption C = 50 + 0.8Y. Assume further that planned investment Ig and net exports Xn are independent of the level of real GDP and constant at Ig = 30 and Xn = 10. Recall also that, in equilibrium, the real output produced (Y) is equal to aggregate expenditures: Y = C + Ig + Xn.

  1. Calculate the equilibrium level of income or real GDP for this economy.

  2. What happens to equilibrium Y if Ig changes to 10? What does this outcome reveal about the size of the multiplier?

Using the consumption and saving data in problem 1 and assuming investment is \(16 billion, what are saving and planned investment at the \)380 billion level of domestic output? What are saving and actual investment at that level? What are saving and planned investments at the \(300 billion level of domestic output? What are the levels of saving and actual investment? In which direction and by what amount will unplanned investment change as the economy moves from the \)380 billion level of GDP to the equilibrium level of real GDP? From the \(300 billion level of real GDP to the equilibrium level of GDP?

Possible Levels of Employment, Millions

Real Domestic Output (GDP = DI), Billions

Consumption, Billions

Saving, Billions (DI – C)

40

\)240

\(244

-\)4

45

260

260

0

50

280

276

4

55

300

292

8

60

320

308

12

65

340

324

16

70

360

340

20

75

380

356

24

80

400

372

28

Depict graphically the aggregate expenditures model for a private closed economy. Now show a decrease in the aggregate expenditures schedule and explain why the decline in real GDP in your diagram is greater than the decline in the aggregate expenditures schedule. What term is used for the ratio of a decline in real GDP to the initial drop in aggregate expenditures?

The economy’s current level of equilibrium GDP is \(780 billion. The full-employment level of GDP is \)800 billion. The multiplier is 4. Given those facts, we know that the economy faces _______ expenditure gap of ___________.

  1. an inflationary; \(5 billion

  2. an inflationary; \)10 billion

  3. an inflationary; \(20 billion

  4. a recessionary; \)5 billion

  5. a recessionary; \(10 billion

  6. a recessionary; \)20 billion
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